IRA Mistakes Create Tax Issues - Contributions

Individual Retirement Arrangements (IRAs) can be a great way to save for retirement because of the tax benefits they may provide. If you're eligible, you can choose a traditional IRA for an up-front tax deduction and defer paying taxes until you take withdrawals in the future. Or if eligible, you might opt for a Roth IRA and contribute after-tax money in exchange for tax-free distributions down the road.

If you run afoul of some of the IRS rules surrounding these accounts, the penalties can be quite stiff—all the way up to a disqualification and taxation of your entire account if you're not careful. Ignorance of the law is no excuse, and with very few exceptions the IRS isn't forgiving of mistakes. These mistakes fall into the categories of contributions, withdrawals and estate planning, which we will discuss in separate articles.

These are the common IRA mistakes that occur related to contributions:

Excess contributionsIf you contribute more than the law allows in any year based on contribution or income limits for your filing status, or age limitations (you can't contribute to a traditional IRA past age 70½), the penalty is 6% of the excess amount for each year in which you fail to take corrective action. For example, if you contributed $1,000 more than you were allowed, you would owe $60 each year until you corrected the mistake. To correct the excess contribution you need to withdraw the excess amount, plus any earnings specifically tied to the excess contribution, by the due date (plus extension) of your tax return for the year of contribution (generally October 15th of the following year). Alternatively, you could recharacterize the excess contribution before the due date, plus extension, as a contribution to another IRA type (e.g., you're over the limit for a Roth IRA because of income limitations, but you're eligible for a traditional non-deductible IRA). Finally, you could leave the excess contribution alone. You might choose to do this if the amount is so small that the 6% penalty isn't worth the hassle of withdrawal or recharacterization, or if your contribution has increased in value so much that the tax on the earnings (plus 10% penalty if you're under 59½) would be worse than paying the penalty. In that case, you would pay the 6% penalty for one year, and then count the excess as a deemed contribution in the next year, assuming you're eligible to make a contribution at that point.

If you invest directly in collectibles the amount invested will be considered distributed to you in the year invested, subject to applicable tax and 10% penalty if the premature distribution rules apply. Owning real estate directly in an IRA isn't prohibited, but you could find yourself engaged in a prohibited transaction if you buy and sell individual properties and are not extremely careful. If you want to invest in precious metals or real estate in your IRA, then a mutual fund or exchange-traded fund (ETF) would probably be a better choice. But if the ETF or mutual fund ever made an in-kind distribution of a prohibited investment such as gold bullion, it would still be subject to prohibited investment rules.

Prohibited transactionsRegardless of what you invest in, you need to avoid prohibited transactions, since they could cause your entire IRA to lose tax-deferred status. Prohibited transactions in your IRA include:

• Borrowing money from it (for example, treating your IRA as a margin account)
• Selling property to it
• Receiving unreasonable compensation for managing it
• Using it as security for a loan
• Using IRA funds to buy property for personal present or future use

If you engage in a prohibited transaction, your entire account stops being an IRA as of the first day of that year and the account is treated as having made a taxable distribution of all its assets to you based on fair market value on the first day of the year (plus additional excise taxes in some instances). This is as bad as it sounds—engaging in a prohibited transaction could result in the destruction of your IRA.

Rollovers
You can make unlimited direct trustee-to-trustee transfers of your IRA funds in any given year. BUT, when you take receipt of the money yourself, you face a number of restrictions. First, you have 60 days to redeposit it into the same or another IRA or it counts as a taxable distribution (plus penalty if you're under age 59½). Moreover, you are only allowed one such "rollover" per year. If you deposit the funds into another IRA and then attempt another rollover with the same funds in the same year, then the withdrawal is immediately taxable. One other thing to keep in mind is that when you take receipt of the money it's subject to 20% withholding. You'll get the withholding back when you file your tax return (assuming you don't violate the rollover rules), but in the meantime you have to come up with 100% of the money in 60 days. Bottom line: If you need to switch custodians, play it safe and stick to the direct trustee-to-trustee transfer method.

Roth conversionConverting from a traditional IRA to a Roth IRA might make sense if you're sure you'll be in a higher tax bracket when you take future withdrawals, can pay the conversion tax from outside sources now, and have a reasonably long time horizon. However, even if you meet these three basic criteria you should consider the following potential conversion traps:

Hidden taxes. A Roth conversion analysis is shouldn't just look at the marginal ordinary income tax impact. Depending on your modified adjusted gross income (MAGI) before converting, the additional conversion income could trigger increased taxation due to any or all of the following factors:

Taxability of Social Security benefits

Triggering alternative minimum tax (AMT)

Phase-out of exemptions, deductions, or eligibility for other tax breaks

Potential financial aid loss because of a higher AGI

Aggregation rule for partial conversions involving after-tax money. If you have made nondeductible contributions to your traditional IRA in the past, you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth. The IRS looks at all traditional IRAs as one when it comes to distributions, including Roth conversions. Traditional IRA balances are aggregated so that the amount consists of a prorated portion of taxable and nontaxable money.

Failing to first take RMDs, if applicable. You can't avoid taking required minimum distributions by converting funds.

Premature withdrawal penalty. If you're under 59.5 you'll pay a 10% penalty if you withdraw funds to pay the conversion tax (a bad idea anyway). Also, even though withdrawals of regular contributions made to a Roth IRA are normally penalty free, you can't convert from a traditional IRA to a Roth in order to avoid the premature withdrawal penalty (unless you wait at least five years or to age 59.5, whichever is less).